December 11, 2011

Cash Flow Estimation for Expenditure Proposals

For each expenditure proposal, engineers have to estimate revenues and expenditures years wise in the future. They need to estimate salvage values of capital assets at the end of project period.

The cash flow estimation has to follow certain standard practices as they have to be comparable across projects in an organization and in conglomerate companies across various subsidiaries.

Cashflow Estimation - Some Principles

Cash flows of a project have to be estimated for a time horizon. The time horizon is the minimum of physical life of the plant, technological life of the plant, or the product market life.
In estimating the cash flows of a project, incremental principles (that considers all incidental effects), separation of investment and financing principle, post-tax principle and consistency principles are employed.
Incremental principle
In an existing company, the cash flows are to be estimated by evaluating the cash flows of the company with the project and without the project. The difference will be incremental cash flows related to the project.
Separation of investment and financing principle
In a standard capital expenditure analysis, interest payment to be made on borrowings is not brought into the picture. Borrowing is considered a financing decision and its impact is included in the cost of capital estimation. Hence cash flow estimates do not have any interest payment of component.
Post-tax principle
Tax impact on the cash flow is considered and after tax cash flows are estimated.
Consistency principle
The inflation expectation built into estimation of revenues and costs and cost of capital have to be consistent or same.

Some Examples Issues That I came Across Recently

1. Acquisition of a software by a design department.
2. Replacement of boiler tubes.
3. Replacement of an electronic equipment as some cards used in the equipment are not available anymore for replacement (the equipment manufacturer is not supplying those cards anymore as the equipment is phased out for production).

The approval authority for the expenditures wants the concenred departments to calculate the payback period for the expenditure proposals.

Payback Period

Payback period is an investment appraisal metric. This period will indicate the number of years it will take to get back the cash initially invested in a project. The period is calculated using the estimated cash flows, both outflows and inflows.

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